![]() ![]() Let’s take an example of two similar-sized companies (A & B) growing their sales at a similar rate (say 15%) in the past. ![]() An illustration of the importance of free cash flow: negative FCF), have a very low/negative margin of safety. Needless to say, the companies, which have their capex much higher than their entire CFO over the last 10 years (i.e. I find that the companies, which have achieved their sales growth in the past by using the minimum amount of CFO as capex have a significantly higher margin of safety than the companies which have used almost all CFO. In our assessment of the margin of safety in any stock investment, free cash flow plays an important role. Therefore, positive free cash flow generation by a company over the last 10 years, is one of the key criteria for stock selection for me. Their business should be a source of cash for me and not the other way round. I, as a shareholder, expect the companies I own, to be cash-generating machines. Or those degrees might be fake and cash has already gone down the drain! In both cases, the investment done is not of much use. It resembles an individual who is continuously garnering degrees after degrees costing millions of rupees/dollar, without ever putting those skills to commercial use. However, if a company is not able to generate positive FCF over long periods of time (I assess them over the last 10 years), then the company resembles a continuous cash guzzling machine. Such companies might be taking education loans to generate future wealth. Therefore, we should not worry about the situation where a company is not able to generate positive FCF for a few years. Similarly, for companies, the investment in plants & machinery and technology is like an educational loan, which increases future earnings potential. An education funded by a loan is an investment, which has the potential of increasing the skills set, earning ability and future wealth of a person and therefore is considered a good investment. This argument is a valid argument just like an educational loan for an individual. It might be argued that the investments done today by the company would lead to revenue & profits in the future and would generate wealth for the shareholders. In both cases, the situation of companies continuously raising debt/equity to meet their cash flow requirements becomes less attractive for investors as compared to the companies that are able to meet their funds’ requirements from their cash flow from operations. These funds, if raised from debt, would decrease profitability by interest expense and increase bankruptcy risk and if raised from equity, would lead to dilution of the stake of existing shareholders. Such a company would have to raise funds from additional sources like debt or equity dilution to meet its requirements. If a company does not have positive free cash flow, it means that it is spending beyond its means. The scenario is exactly the same for companies as well. Debt pressure increases the bankruptcy risk and leads to stress in our lives. The debt, which we raise to fund our expenses, needs to be paid at predefined intervals irrespective of the fact whether we are able to save in future/have our job intact or not. ![]() We would have to borrow from relatives/banks etc. are not able to save anything, then our financial health is going to suffer a lot in future. If we as households are not able to manage our expenses within our means of income, i.e. (NFA + CWIP) at the end of the year – (NFA + CWIP) at the start of the year + Depreciation for the yearįree cash flow (FCF) is the most essential feature of any business as it amounts to the surplus/discretionary cash that the business/company is able to generate for its shareholders. FCF is the equivalent of savings for a household. (GFA + CWIP) at the end of the year – (GFA + CWIP) at the start of the year It can also be calculated by deducting net fixed assets & CWIP at the start of the year from the net fixed assets & CWIP at end of the year and adding back the depreciation for the year.
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